The Invisible Hand: How Markets Work
1. The strangeness of markets

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Maria wants some gasoline to drive home for the weekend. So she goes to the Seven Eleven and pumps in three gallons and pays with her credit card. She doesn't have to call in advance, seek the mediation of some gasoline boss, negotiate with oil drillers, or haggle over price. She gets her 3 gallons in exchange for $10.50, at $3.50 a gallon. That's all. (We mean that's all there is to the transaction; to Americans, nowadays, $3.50 a gallon is a lot to pay for gas! Then again, it would be cheap for Europeans.)

You engage in such deals routinely. But consider how strange they are. A nomad on the Gobi Desert, lacking a gasoline station over the next dune, would marvel. When you think about it, that you can get gasoline and a variety of other things in Midtown Manhattan or a village in Sussex amazes. Most of what you buy was produced thousands of miles away, days or months ago. Nobody knows about Maria's low tank on September 14 or about her sudden decision to drive from college to the Pilsen neighborhood in Chicago that Saturday. No one engages in any conscious planning, at any rate to satisfy her particular want. And yet it gets satisfied.

Economists call Maria's purchase of gasoline a market transaction. Nothing mysterious so far. A market transaction is a voluntary trade of one thing (such as $3.50, which could be spent on ice cream or education) for another (such as a gallon of gasoline).

The word "market," though, brings to mind the frantic transactions between buyers and sellers on the floor of the New York Stock Exchange or the Chicago Board of Trade, or perhaps the haggling at a flea market. But the trafficking of second-hand tickets outside a rock concert constitutes a market too. Dozens of people wave tickets in the air. Buyers make offers. Sellers shout prices. Buyers put up fingers to signal how many tickets they want. "How much?" "Eighty bucks each." "For balcony seats that cost you forty?" "Yeah. Take it or leave it."

In fact markets are all over the place. We speak for example of the "market" for houses in Los Angeles even though we don't see buyers and sellers gathered together in one place bargaining over them, as in the corn pit of the Chicago Board of Trade. The people who put their house up for sale are potential sellers. Those who are looking for houses in Los Angeles, wherever they are not housed, are potential buyers.

Economists regard Maria's transaction at the gasoline station as analogous (similar, but not identical) to the visible, face-to-face transactions that occur on the trading floor of a stock exchange or on a street outside a rock concert. When she makes her purchase, she is said to enter the gasoline "market." She is one of many buyers of gasoline, just as the gasoline station is one of many sellers.

Using the analogy, we say that a market exists in any situation where the following five features are present:

  1. a thing or service or . . . whatever for sale or purchase;
  2. some so-called suppliers (owners) of the item are willing and able to sell it---at some price;
  3. some demanders (buyers) are willing and able to pay for it---not at ay old price, but at some price;
  4. the product or service is sold at a certain price; and
  5. buyers pay for the item using an acceptable means of payment (usually money, although other goods or services may also be used---called "barter").

The thing or service does not have to be sharply defined to have a market. Houses have a market, but houses come with thousands of varying features particular to each one---granite counter tops; in-house pool; bad neighborhood; good schools; and on and on.

The market does not have to be an "open outcry market" like the Chicago Board of Trade. If you have or would be willing at some price to have a job, you are a supplier in a labor market, even though it doesn't work by the demanders---the employers, that is---gathering outside your apartment and crying out bids of wages per hour

The suppliers and demanders do not need to be located in one literal marketplace or in one city or in one country. If you own a car, or at some price would like to, you are a demander of cars, even if the car being bid for was made in Korea many thousands of miles away from your home in Dallas. In fact the market for corn for delivery on October 1 is not literally located anywhere, on the trading floor of the Chicago Board of Trade, for example. "The" market is all the actual and potential buyers and sellers of corn, who may be located in Brazil or Japan or Lone Tree, Iowa. It has no location.

The "certain price" does not have to be the same for everybody, or to settle down to a particular figure for months at a time. If you buy a roundtrip airline ticket to New York, you are buying at $250, even though airlines often sell the seat right next to you at twice the price to a last-minute business traveler. If you buy a head of iceberg lettuce, you are buying in the lettuce market at a certain price on August 15 that will not be the same as on December 15, out of season.

The "acceptable means of payment" does not have to be money alone. The analogy can be stretched far, far beyond cash. An extreme example is political corruption, in which jobs in the statehouse are "for sale," by analogy, if the job taker "pays" in campaign work on election day.

Look at the market for haircuts. You may not think of yourself as "entering a market" when you get (or give) a haircut. If you're a woman you think of it instead as a traumatic experience in which you decide to cut off all that long hair. Gak. But getting a haircut, the economist claims, is very much like buying shares of stock on the New York Stock Exchange. A haircut is a service a hairdresser exchanges for money. You can see ten haircuts getting done just as you can see ten stocks getting traded. And haircuts have a price, though varying a lot from shop to shop even in a small city.

Prices Up or Prices Down?

Potential sellers of houses customarily start by asking a high "asking" price and then come down over the weeks and months if no bid comes in. It's known as a "Dutch" auction - starting high, letting the price fall, and concluding the market transaction---handing over the goods for the money---when someone makes a bid. It's used for example in the great wholesale flower market of Aalsmeer close to Amsterdam in Holland. The Dutch dominate the flower market of Europe, hundreds and hundreds of trucks driving into Aalsmeer every night and driving out filled with flowers every day. In amphitheatre-type rooms devoted to each type of flower a big clock-like meter registers the current asking price. Flowers roll through the front of the room on little carts. The lot of flowers is announced and the meter starts down: 100 euros a bunch, 99, 98, 97, . . . Hundreds of buyers sit each at his desk (few women are involved), waiting to press a button each has in front of him to stop the clock. If a buyer's hand is fast enough at the price he thinks is profitable, he gets the lot.

Ordinary auctions of farm equipment at a bankruptcy sale or the high-art market for million-dollar paintings are examples of the "English" auction, in which, unlike a Dutch auction, the asking price begins low and is driven higher by the bidding. That's how "Dr Gachet," a painting by the Dutch artist Vincent van Gogh, fetched in 1989 a (then) record $82,5 million at auction. Picasso's "Boy with a Pipe" sold in 2004 for over $104 million. And in the summer of 2006 an heir to the Estee Lauder fortune paid $135 million for "Golden Adele," by Gustav Klimt, the standing record.

Which is better? Economists argue that roughly they are the same. With the same buyers and sellers of the same item, going up from a low figure until the transaction happens will result, they claim, in the same price as starting from a high figure and going down. Why? Well, turn the question around. The buyers and the sellers and the item to be sold are the same in the two institutions, Dutch or English, aren't they? So why would a mere method of bidding change---much---how the deal turns out? In particular it certainly can't be that, say, the English method always favors buyers and the Dutch favors sellers. If method X favors buyers, the sellers would leave until method not-X were installed. And vice versa. That the Dutch auction is the method in Aalsmeer and the English method at Sotheby's in London must depend on some more subtle, and minor, advantage one has over the other than "English auctions grossly favor buyers."

The analogy with obviously well-functioning markets like the New York Stock Exchange or the wholesale flower market in Aalsmeer is never perfect. That's the point of an analogy. If you say that the "war" on terror is like World War II you are claiming that in some important respects it is, not that we should now in the "war" on terror as we did in The Big One make Sherman tanks or invade France. The market for haircuts, as the trading floor of the New York Stock Exchange is. That's called by the professors of rhetoric a "disanalogy," that is, a feature in which the analogy doesn't quite work. Nor does each hairdresser shout her price in a crowd of other hairdressers. He or she probably has the price posted next to the cash register, and will politely mention it when your haircut is finished, and expect in some countries a tip as well. There's no auction as in Aalsmeer, no mass of competing buyers and sellers, and in most countries no haggling. Even so, the haircut market has all five essential features of a market: a service rendered, buyers, sellers, means of payment, and a price.

Concept Check 1: The little neighborhood grocery where people stop to buy a quart of milk is often called something like "Village Market." Is it, in fact, a market, economically speaking?